Principles of Economics
Distorting and Undistorting
Competitive Markets
Externalities: Introduction
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J. Bradford DeLong
U.C. Berkeley
Competitive Markets in Equilibrium
Make the Right Decisions…
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For five reasons:
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They figure out how much is to be produced and sold—enough to
power all win-win transactions, and no more…
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They figure out who should produce—all those with an opportunity cost
less than the market equilibrium price…
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They figure out who should not produce—all those with an opportunity
cost more than the market equilibrium price…
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They figure out who should consume—all those with a willingness-topay higher than the market equilibrium price…
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They figure out who should not consume—all those with a willingnessto-pay lower than the market equilibrium price
The Competitive Market Is
Perfect, Except for…
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Six kinds of meddling market mishaps—failures—in
competitive markets: Shaggy, Scooby… no, that’s not it. It’s:
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…the wrong distribution of purchasing power and
wealth—maldistributions
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…people who misapprehend what their interests really
are—miscalculations
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…commodities where people do not know what they
are really buying or selling—information asymmetries
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…commodities where use is divorced from ownership
—non-excludibilty!
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…commodities where one person’s use does not
preclude another’s—non-rivalry!
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…commodities where the costs and benefits are not
internal to the parties to the transaction—externalities
Plus: market power—things that make markets not
competitive
Six Classes of Market Failure
in Competitive Markets
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Six cases:
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Maldistribution
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Miscalculation
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Information
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Non-excludibility
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Non-rivalry
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Externality
In all six of these cases, the competitive market in equilibrium is not the societal
planning, calculation, and allocation mechanism we are looking for: it will fail
Six Classes of Market
Failure II
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We have already talked about: maldistribution failures
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We won’t talk about: miscalculation failures
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We are leaving for future classes: information failures,
non-excludibility failures, and non-rivalry failures
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Market power—sustainable market power, that is—
is linked…
Today’s topic: externality failures
Ladies, Gentlemen, and Large
Intelligent Semi-Talking Dogs Who Did
Not Go to U. Mass, to Your i>Clickers!
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To refresh your minds, a maldistribution failure arises when:
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A. The marginal utility of wealth is different for some than for others
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B. The distribution of wealth is awry and so at the margin people’s
ability to buy things does not correspond to our ideas of who
needs and deserves things.
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C. Some have gotten rich and others poor through luck—or
through crime, or through unfair inheritance, or through fair
inheritance of the fruits of past crimes.
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D. All of the above
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E. None of the above (except D)
Ladies, Gentlemen, and Large Intelligent
Semi-Talking Dogs Who Did Not Go to
U. Mass, to Your i>Clickers!: Answer
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To refresh your minds, a maldistribution failure arises when:
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A. The marginal utility of wealth is different for some than for others
•
B. The distribution of wealth is awry and so at the margin people’s
ability to buy things does not correspond to our ideas of who
needs and deserves things.
•
C. Some have gotten rich and others poor through luck—or
through crime, or through unfair inheritance, or through fair
inheritance of the fruits of past crimes.
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D. All of the above!
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E. None of the above (except D)
Today We Do Externalities
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In the context of our Lego
Movie example market:
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Lego bric
manufacturers sell…
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Master builders buy…
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But Lego bric factories
emit toxic plasticized
smoke that pollutes
Cloud-Cuckoo Land…
Today We Do Externalities
II
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Lego bric
manufacturers sell…
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Master builders
buy…
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But Lego bric
factories emit toxic
plasticized smoke
that pollutes CloudCuckoo Land
Today We Do Externalities
III
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Lego bric
manufacturers sell…
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Master builders buy…
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But Lego bric factories
emit toxic plasticized
smoke that pollutes
Cloud-Cuckoo Land
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And Unikitty is very
unhappy
Ladies, Gentlemen, and Products of
Genetic Engineering Gone Awry, to
Your i>Clickers?
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Should We Expect the Right Decisions to Be Made
by a Market with an Externality?
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A. Yes, a competitive market in equilibrium
produces Pareto-optimal results
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B. No. When the market makes the right
decisions, it does so because it takes account
of and properly weighs the consequences.
With externalities present, it does not do so.
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C. Yes, a competitive market in equilibrium
maximizes the social welfare function
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D. No—but the costs of using government to
try to fix it will generate government failure
problems worse than the errors of the
marketplace.
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E. Yes, because this externality does not
involve a good or service sold on the market it
has no effect on market optimality
Ladies, Gentlemen, and Products of
Genetic Engineering Gone Awry, to
Your i>Clickers?: Answer
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Should We Expect the Right Decisions to Be Made by a Market with an Externality?
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A. Yes, a competitive market in equilibrium produces Pareto-optimal results
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B. No. When the market makes the right decisions, it does so because it takes
account of and properly weighs the consequences. With externalities present, it does
not do so.!
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C. Yes, a competitive market in equilibrium maximizes the social welfare function
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D. No—but the costs of using government to try to fix it will generate government failure
problems worse than the errors of the marketplace.
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E. Yes, because this externality does not involve a good or service sold on the market it has
no effect on market optimality
I say B. C is rarely true, B is sometimes true—but not with externalities—and E is simply
wrong. D is, I think, ideology: whether government failures from attempting to correct
externalities are cures worse than the diseases is an empirical question that varies from
case to case: not a theoretical a priori conclusion.
No, We Should Not Expect the Right
Decisions to Be Made by a Market with
an Externality
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Individual bric producers sell only if the market price is greater than
their opportunity cost…
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Individual master builders buy only if the market price is less than
her willingness-to-pay…
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All possible win-win deals between master builders and bric
producers are made, and no not win-win deals between those two
groups are made…
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But Unikitty doesn’t get a say—and her lungs are coated with
plastic smoke…
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This cannot work out well when the market gives some important
stakeholders no voice in the decision at all…
So What Should the Government
Do?: To Your i>Clickers
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A. Forbid bric producers to use any
production process that pollutes CloudCuckoo Land?
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B. Tell Unikitty to go and use the courts—to
sue the individual bric producers under the
doctrines of tort law for damages to repair the
economic harm that air pollution does them?
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C. Tell Unikitty to buy a gas mask?
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D. Impose a quota on maximum allowable
production in order to limit the damage from
pollution?
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E. Impose a tax to force bric producers (and
master builders!) to take account of the
damage they inflict on Cloud-Cuckoo Land,
and then use the revenue for pollution
remediation (or some other benefit to CCL?
So What Should the Government
Do?: To Your i>Clickers: Answer
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A. Forbid bric producers to use any production process that pollutes
Cloud-Cuckoo Land?
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B. Tell Unikitty to go and use the courts—to sue the individual bric
producers under the doctrines of tort law for damages to repair the
economic harm that air pollution does them?
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C. Tell Unikitty to buy a gas mask?
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D. Impose a quota on maximum allowable production in order to limit
the damage from pollution?
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E. Impose a tax to force bric producers (and master
builders!) to take account of the damage they inflict
on Cloud-Cuckoo Land, and then use the revenue
for pollution remediation (or some other benefit to
CCL?!
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I say that the answer is going to be E: A is wrong: to
forbid bric production may mean that we are giving
up something of immense social benefit in order to
guard against what may be a small harm. B is
wrong: tort law has not, historically, dealt well with
externalities. C is also wrong: why should Unikitty
be required to pay for dealing with a situation she
did nothing to create? And D is a less-destructive
but still flawed version of A. that leaves E…
Arthur Cecil Pigou Rulz!
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Yes!:!
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E. Impose a tax to force
bric producers (and
master builders!) to
take account of the
damage they inflict on
Cloud-Cuckoo Land,
and then use the
revenue for pollution
remediation (or some
other benefit to CCL!
A.C. Pigou, The Economics
of Welfare